The debt-to-income ratio surprises a lot of loan applicants who always thought of themselves as good money managers. Whether they want to buy a house, finance a car or consolidate debts, the ratio determines whether they’ll be able to find a lender.
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If your credit scores are good and your income is stable, you should have no problem getting approved for a new loan … right?
Unfortunately, you could still face obstacles. Lenders may decline your applications for a number of reasons, including if you have a debt-to-income ratio (DTI) that’s “too high.”
Debt-to-income ratios can be difficult to understand and frustrating to deal with, since they only tend to come up when you’re being denied financing. That’s why we wanted to break down this often misunderstood but important ratio and offer you some tips on how to improve your DTI.
Of course, you can always ask your lender for suggestions or talk to a certified credit counselor for more in-depth guidance on how to make long-term improvements to your DTI and overall finances.
What Is a Debt-to-Income Ratio?
Debt-to-income ratio (DTI) looks at how much of your income goes towards debt payment. Lenders use this figure to determine whether or not you can afford to take on more debt, such as a car or home loan. Having a lower DTI makes you more likely to be approved for loans.
To calculate your DTI, you can add up all of your monthly debt payments (the minimum amounts due) and divide by your monthly income. Then, multiply the result by 100 to come up with your ratio.
(Monthly Debt Payments / Income) x 100 = DTI
For example, let’s say you pay $2,000 a month for a mortgage, plus $600 for an auto loan and $400 for credit cards, so your total monthly debt payments are $3,000. If your gross monthly income is $7,000, here’s what your DTI calculation will look like:
($3,000 /$7,000) x 100 = 42.9%
Many lenders will decline your mortgage application if your DTI is over 36%, however some may work with ratios as high as 43%.
Front End and Back End Ratios
Understanding DTI can be challenging in itself, but some lenders divide DTI into even further categories. These categories are often referred to as your “front-end” ratio, or housing ratio, and your “back-end” ratio. Here is an explanation of what those terms mean.
Front-End Ratio: This ratio only considers debt related to your housing payment in comparison to your income. The calculation includes your mortgage payment, homeowner’s insurance, real estate taxes and homeowner’s association fees—collectively referred to as PITIA. If you don’t have a mortgage, your rent will be used instead.
- Example: ($2,000 PITIA / $6,000 income) x 100 = 30% Front-End Ratio
Back-End Ratio: Considers all debt payments, including mortgage expenses, credit cards and loans, in comparison to your monthly income.
Lenders prefer a front-end ratio of 28% or less for conventional loans and 31% or less for Federal Housing Association (FHA) loans. For the back-end ratio, many lenders want a max of 36%.
What’s the 43% Rule?
While there are guidelines that many lenders follow, DTI requirements can vary by lender, and more specifically, by loan type. Although conventional mortgage lenders generally have a DTI cut off of 36%, federal law allows most lenders to offer mortgages at up to 46% DTI.
If you’re looking for a mortgage that allows a higher than usual debt-to-income ratio, consider going through the VA, which allows up to 41%, or The Federal Housing Administration (FHA) which may allow up to 50% DTI, under certain circumstances.
For other types of loans, like debt consolidation loans, the allowable ratio could be as high as 49% .
What Is a Good Debt-to-Income Ratio?
There is not a one-size-fits-all answer for what constitutes a healthy DTI. Instead, it depends on several factors specific to you, including your lifestyle, goals, income level, job stability, and tolerance for financial risk.
There are, however, general rules of thumb to consider when determining what is a good debt-to-income ratio:
- 0 to 35%: Lenders consider this a reflection of healthy finances and ability to repay debt. Wells Fargo, for instance, classifies DTI of 35% or lower as “manageable,” since you “most likely have money left over for saving or spending after you’ve paid your bills.”
- 36% to 43%: You may be managing your debt adequately, but you’re at risk of coming up short if your financial situation changes. To use a physical health analogy, your DTI may not rank as obese, but you could benefit from better fitness habits. You may qualify for loans, but you have little room for error. For that reason alone, you should look for opportunities to get your DTI in better shape.
- 44% to 50%: You may qualify for smaller loans, but you’ll have a hard time landing a mortgage. Consider enrolling in a debt management plan or other debt-relief program to improve your ratio and increase your credit-worthiness.
- Over 50%: This is generally regarded as an unhealthy level of debt. It should serve as a red flag warning that you need to reduce your debt burden ASAP. At this ratio, you’ll have trouble qualifying for most loans and are at risk of financial crisis should your expenses rise or income drop. Now is the time to explore credit counseling and/or debt consolidation.
Calculate Your Debt-to-Income Ratio in 4 Easy Steps
Lowering your DTI can be the difference between a dream fulfilled, and disheartening rejection. Before you approach lenders, here’s how to calculate debt-to-income ratio in easy 4 steps, so you can see if it needs improving:
- Add up your minimum payments due toward debt each month, including credit card debt, mortgage (or rent), loans, and debt you’ve cosigned for.*
- Calculate your gross income, including wages, dividends, freelance income, alimony, etc. **
- Make sure to convert each of the above to monthly figures. For example, if your annual income is $60,000, the monthly total is $5,000.
- Divide your monthly debt payments by your monthly gross income and multiply the result by 100.
Monthly Debt Payments That Are Included in the DTI Formula:
When calculating DTI you’ll use the minimum monthly payment that’s due for each of your debts, including debt that you’ve cosigned on. Here’s what is included in debt-to-income ratio in terms of debt payments:
- Credit cards
- Mortgage (including homeowner’s insurance, property taxes and HOA dues)
- Car loans
- Student loans
- Personal loans
- Debt consolidation loans
Income Included in Your Monthly Income When Calculating DTI
Use your gross (before tax) income from all sources to accurately calculate your DTI. Be sure to include:
- Self-employment (verified via tax return)
- Child support
- Social Security
- Investment income (e.g. rental properties, stock dividends, bond interest)
Monthly Payments Not Included in the Debt-to-Income Formula
Many of your monthly bills aren’t included in your debt-to-income ratio because they’re not debts. These typically include common household expenses such as:
- Utilities (garbage, electricity, cell phone/landline, gas, water)
- Cable and internet
- Car insurance
- Health insurance
- Medical bills
DTI Ratio Calculator
Why Debt-to-Income Ratio Matters
While there is no exact DTI cutoff that applies to every loan, there are some accepted standards, especially with federal home loans.
For example, if you qualify for a VA loan, Department of Veteran Affairs guidelines suggest a maximum 41% DTI. FHA loans allow a ratio of 43%. It is possible to get a VA or FHA loan with a higher ratio, but only when there are compensating factors.
The ratio needed for conventional loans varies, depending on the lending institution. Most banks rely on the 36% figure, but it could be higher depending on factors like income and credit card debt.
Larger lenders are more likely to accept a high income-to-debt ratio, but only if you’re a pre-existing customer or if they determine there’s enough income to cover all debts.
Ultimately, evidence shows that the higher the ratio, the more likely the borrower is going to have problems paying. So even if you’re approved, you should still review your budget to see if the new loan is sustainable.
Is My Debt-to-Income Ratio Too High?
You’re probably in a financially stable position if your debt-to-income ratio is lower than the lenders’ standard of 36%, but the lower your DTI, the better off you are.
Though each situation is different, a ratio of 40% or higher may be a red flag for a credit crisis and a sign that it’s time to seek professional help. If you can decrease your debt balances over time, you’ll spend less of your take-home pay on debt and interest, freeing up money for other budget priorities like savings.
How to Improve Your Debt-to-Income Ratio
Whether your lender suggests lowering your DTI, or you’re just hoping to improve your ratio for personal reasons, there are two ways to make improvements:
- Reduce the amount of debt payments you have due each month
- Increase your income
Both of these options are easier said than done, but there are a number of strategies that might work for you.
Lower your debt payments
To work on reducing your monthly debt bills, start by making a list of your expenses. Be sure to include everything from debt to necessities, medical costs, utilities, travel and entertainment. Add it all up.
Then look over each item on the list, starting with the biggest expenses. Can any of them be reduced? Can you get a lower interest rate? Can you eliminate an expense in order to pay off your debt faster?
Other ways to lower your expenses and pay off debt:
- Switch to a more affordable cell phone plan, cable carrier or auto insurance plan.
- Put off large purchases until you have more cash.
- See if you can qualify for a lower, income-based payment plan on your student loans.
- Look into refinancing or consolidating debts with high payments.
- Avoid new debt by cutting up credit cards and canceling retail memberships and automatic, recurring charges.
- Sell unneeded items on Facebook Marketplace, eBay or Craigslist and apply the proceeds to your debt.
To pay down debt more efficiently, and save money in the process, consider using the avalanche method, which prioritizes paying off debts with the highest interest rates first. You can also try the snowball method and pay off the smallest debts first. While it may not be as cost-effective an approach, it can help eliminate one of your monthly debt payments faster and help reduce your DTI.
Increase Your Income
Cutting expenses can only go so far. If you can’t find much extra cash in your budget, try finding a new job or a temporary side job to come up with money to make a dent in your DTI.
Here are some ways to increase your income:
- Research current market pay for your role and ask for a raise
- Look into a promotion or a new job, and make it a habit to do so every few years
- If you’re paid hourly, pick up extra work shifts or work overtime
- Start a small business using a skill or resource you already have
- Use social media or Craigslist to find people who need house cleaning, handy work or babysitting.
- Pick up a holiday or seasonal gig.
Finding a combination of the two–increasing your income plus reducing expenses–is the ultimate solution and might even bring your debt-to-income ratio below the 36% that lenders look for.
If working extra hours doesn’t appeal to you, remember – this is just temporary. Once you use the income to pay off debt, you can reduce your DTI and your labor efforts.
Does My Debt-to-Income Ratio Affect My Credit Score?
The good news is your debt-to-income ratio has no bearing on your credit scores, since credit-rating agencies don’t include your income as a factor. The bad news: The more debt you owe, the lower your scores will be.
Credit score calculators factor your credit utilization rate (i.e. the amount of your available credit that you’re currently using) in determining your scores, so it’s no surprise that people who carry high debt burdens often have low credit scores.
For example, if you have a $10,000 limit on your credit card and your current card balance is $9,000, the resulting credit-utilization ratio (90%) won’t reflect kindly on your credit score.
The bottom line is that you’ll have higher credit scores (not to mention better financial health) as you reduce your debt balances.
Why Is Monitoring Your Debt-to-Income Ratio Important?
Calculating your debt-to-income ratio can help you avoid “creeping indebtedness,” or the gradual rising of debt. By monitoring your debt-to-income ratio, you can:
- Make better decisions about buying on credit and taking out loans.
- See the benefits of making more than your minimum credit card payments.
- Anticipate and avoid major credit problems.
Creditors look at your debt-to-income ratio to determine whether you’re creditworthy. Letting your ratio rise above 40% may:
- Jeopardize your ability to make major purchases, such as a car or a home.
- Keep you from getting the lowest available interest rates and best credit terms.
- Cause difficulty getting additional credit in case of emergencies.
Debt-to-income ratios are powerful indicators of creditworthiness and financial condition. The best practice is to know your ratio and keep it low.
Speak to a Credit Counselor About Lowering Your DTI Ratio
If you’re turned down for a loan because of high DTI, don’t consider it a dead-end.
You may need to work on improving your financial situation, but you don’t have to do it alone. For most people, the best way to get help is through free or low-cost professional guidance from a certified credit counselor, and it’s just a phone call away.
When you talk with a credit counselor, they can guide you through your full list of options for improving your DTI and improving your finances, from adjusting your budget, to using nonprofit debt management services to consolidate your debt payments.
About The Author
Sarah Brady is a Personal Finance Writer and educator who's been helping people improve their financial wellness since 2013. Sarah writes for Experian, Investopedia and more, and she's been syndicated by Yahoo! News and MSN. She is a workshop facilitator and former consultant for the City of San Francisco's Affordable Home Buyer Programs, as well as a former Certified Housing & Credit Counselor (HUD, NFCC). Sarah can be contacted via sarahcbrady.com.
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